Safeguards to the U.S. Banking System Should Not Be Dismantled

Top of the Ninth

"...along with the dismantling of these archaic laws, public policy
officials concerned over U.S. competitiveness must overcome unfounded
trepidation over the separation of finance and commerce..."*

L. William Seidman, chairman
Federal Deposit Insurance Corp.

*Testimony before the International Competitiveness Task Force, Committee
on Banking, Finance and Urban Affairs, U.S. House of Representatives,
March 22, 1990.

In testimony before Congress, Mr. Seidman said that without his recommended
changes to U.S. banking structure and powers, the U.S. banking system
will lose its ability to compete in the global financial market. That
loss will "weaken the viability of our banking system and ... the economic
strength of our nation worldwide," he maintains.

Mr. Seidman, who is not alone in his assessment, would go further than
almost anyone else in restructuring the U.S. banking system and enlarging
bank powers. He urges "dismantling of ... archaic laws" including
Glass- Steagall, which separates commercial and investment banking, and
the Bank Holding Company Act, which separates banking and commerceto
enable the formation of so-called universal banks.

I have to wonder if Mr. Seidman and others have lost sight of why banks
are subject to these and other laws regulating the way they do business.
The thesis of an essay by E. Gerald Corrigan, the immediate past president
of the Minneapolis Fed and current president of the New York Fed, published
in this bank's 1982 annual report, captures
what I believe is the reason for such lawsbanks are special. The
banking system has a special place and set of functions in our economy.

The "archaic laws" Mr. Seidman refers to, among others, were put in
place not to develop the largest or the most profitable banks in the world,
but to provide a safe and sound banking system for the benefit of the
U.S. economy. Anyone advocating major changes to banking structure and
powers should have the burden of proving the need to do away with the
legal structure intended to protect the U.S. economy from a major disruption
in the banking system.

In 1913, Congress passed the Federal Reserve Act, the first piece of
banking legislation of this century to address the country's repeated
banking panics. Among other things, it established a central bank system
to provide liquidity to banks as needed to provide stability.

In part because the Federal Reserve didn't properly use its power to
provide liquidity, thousands of banks failed during the early '30s. As
a result of these mass failures, Congress enacted the Banking Acts of
1933 and 1935, which included the National Bank Act, Glass-Steagall, the
federal deposit insurance system and significant amendments to the Federal
Reserve Act. To further protect the banking system, Congress passed the
Bank Holding Company Act of 1956 to separate banking from commerce. In
1970, that law was amended to include corporations that owned even a single
bank.

Like public utilities, banks are not allowed to operate unfettered in
the marketplace; rather, they are given a limited market advantage of
a geographic and activities franchise. In addition, they derive a market
advantage from the federal safety net of access to borrowing from the
Federal Reserve and deposit insurance. These market advantages must still
have value, because in spite of all the market opportunities allegedly
now denied U.S. banks, I am not aware of any bank that has relinquished
its charter to engage in other business.

No one familiar with the yet unresolved thrift problem and numerous
and substantial bank failures of the 1980s should have any doubt about
the economy's vulnerability to misadventures in the banking system. Driven,
at least in part, by deregulation of some activities and fueled by the
problems inherent in deposit insurance, these misadventures caused the
insolvency of the Federal Savings and Loan Insurance Corp., the diminution
of the reserves of the Federal Deposit Insurance Corp. and a huge, but
yet undetermined, addition to the federal deficit.

I have reflected at length on the alleged competitive problems confronting
U.S. banks to understand what could justify the advocated changes in spite
of these problems of the '80s. The allegations are unsupported by empirical
evidence, and I don't believe the proponents for change have met the burden
of proof that should be required of them.

Much is made of the dramatic changes that have taken place in the global
marketplace in the last decade. Not to trivialize globalization, as the
process is often called, it isn't something that began in the 1980s. It
began with the first people to "go down to the sea in ships," uncertain
of how far they could travel before falling off the edge of the earth.
Technology has increased the scope and velocity of international trade
over time, but the changes of the 1980s are only marginally significant
when viewed in historic perspective. Certainly, the '60s and '70s were
not the dark ages of international business and finance.

If there is reason to worry about globalization, however, it should
not involve the ability of U.S. banks to compete, but the risks related
to the growing interdependence of markets. Global financial markets are
vulnerable to the consequences of risk being transmitted from one to another.
That being the case, it seems to me that the structure in place to protect
the U.S. banking system is more important than ever.

Why this growing anxiety over globalization? Probably because in the
past 30 to 35 years, the relative position of the U.S. economy in the
world changed as several other countries emerged as major economic powers.
In addition, U.S. trade imbalances driven by large budget deficits emerged
in the 1980s. While these changes are not the result of the alleged competitive
disadvantage of U.S. banks, many in the United States have become sensitive
to real or perceived unequal treatment of U.S. businesses, including banks.
This is especially true with regard to Japan. Similar concerns are raised
by the unification of the European Economic Community (EC) in 1992.

What is the evidence that U.S. banks are unable to compete in this environment?
The only empirical evidence offered to demonstrate the competitive disadvantage
of U.S. banks seems to be their size relative to other banks in the world,
and the increasing market share of Japanese banks throughout the world,
including the United States.

U.S. banks are no longer among the largest in the world. Only one, Citicorp,
is among the 25 largest, and Japanese banks comprise the 10 largest and
17 of the 25 largest. Much of the decline in the relative size of U.S.
banks as compared to foreign banks can be traced to the substantial decline
in the dollar in relation to the yen, deutsche mark and the other major
currencies, between 1985 and 1988.

In addition, the U.S. banking system bears little or no resemblance
to the banking systems of most other industrialized countries. The assets
of the U.S. banking system are dispersed among almost 13,000 banks created
by 51 chartering authorities (53 supervisory agencies). The assets of
the banking systems of most other industrialized countries are concentrated
in relatively few institutions created by a single chartering authority
in each country. Even though movement toward interstate banking is reducing
the number of U.S. banks, it's doubtful that even full interstate banking
will result in a system that resembles those of Germany and Japan.

In any case, does size matter? Are bigger banks better able to compete?
I assume the concern for the competitiveness of U.S. banks is toward profitability.
By traditional measures such as return on assets and return on equity,
U.S. banks are more profitable than much larger Japanese banks. There
certainly is no evidence that efficiency or economies of scale are achieved
by growing from a $200 billion to a $300 billion bank. Indeed, there is
no correlation between asset size and the profitability of an institution.

With regard to concerns about market share, it is often said that U.S.
banks can't compete with Japanese banks because the Japanese are willing
to make loans on very small margins just to gain market share. As a regulator
concerned about safety and soundness, I would not want U.S. banks competing
for such credit in the interest of gaining market share.

Also, while it appears that Japanese banks have a lower cost of capital
and some liabilities, that is not a function of bank size. Regardless,
whatever motivates Japanese banks to make lower cost loans to U.S. businesses,
I would think that those responsible for public policy would be pleased
with the resulting benefit to the U.S. economy.

Even those who advocate more bank powers are concerned about the exposure
of the federal safety net. That concern should be heightened by the doctrine
of "too big to fail," which is based on the notion that the economy could
not tolerate the failure of a large bank. Although many support the doctrine,
I doubt that anyone can be very comfortable with it. Given that, why should
the United States be so anxious to allow banksthat are already too
big to failto expose the safety net to greater risk by becoming
even bigger? If the bank that is too big to fail is a universal bank,
could the bank and its non-bank activities really be unraveled when it
came time to employ the safety net?

It is also asserted that countries such as Japan, soon to be followed
by the EC, create legal impediments that put U.S. banks at a competitive
disadvantage with foreign banks, both in the United States and in the
host country. What are the legal impediments to U.S. banks competing with
foreign banks? U.S. law permits U.S. banks to engage, directly or through
holding company subsidiaries, in most of the activities allowed to banks
in the host countries. Similarly, foreign banks aren't allowed to do anything
in the United States that is prohibited to U.S. banks.

Nevertheless, competitive disadvantages pose safety and soundness risk,
some say, because U.S. banks that are losing business to non-bank competitors
and foreign banks must take on riskier loans to maintain profits. Additional
powers are intended to enable U.S. banks to diversify risk by competing
for financial services currently barred to them.

Diversification of risk is a sound practice, but I have to question
the wisdom of diversification through transactions of at least undetermined
risk to safety and soundness. As for profitability, the argument is flawed
because there are many U.S. banks of all sizes doing quite well from traditional
banking business. The recent huge losses experienced by some U.S. banks
appear to be related to their disregard for sound underwriting principles
rather than competitive disadvantages.

In sum, the proponents of change have not made the case that would justify
dismantling a legal structure intended to protect the U.S. economy from
a disruption in the nation's banking system, particularly if changes add
uncertain risk. There are, indeed, more pressing issues related to bank
structure about which Congress should be concerneddeposit insurance
reform, for examplebut the issue of the competitiveness of U.S.
banks is not among them.

Melvin L. Burstein is the senior officer over banking supervision
at the Federal Reserve Bank of Minneapolis.